Performance based fees have become increasingly popular for investment advisors in recent years. While they can align incentives between advisors and clients, there are also some hidden issues to be aware of. This article will analyze the pros and cons of performance based fees for investment advisors and provide recommendations on how to implement them appropriately.
Performance fees incentivize advisors to take inappropriate risks
One of the main criticisms of performance based fees is that they may incentivize advisors to take inappropriate risks in order to generate higher returns. This could involve shifting the portfolio towards riskier assets or strategies that have a greater chance of big gains but also bigger potential losses. Advisors should be transparent about their investment approach and risk management. Setting reasonable performance hurdles can also prevent excessive risk taking. Clear communication of risks and regular reviews of the appropriateness of the strategy for the client’s goals are key.
Bias towards asset gathering over asset management
With performance fees, the more assets an advisor has under management, the higher their overall fees. This may shift the focus towards gathering assets rather than effectively managing them. Advisors should have reasonable account minimums and be motivated by delivering results rather than asset accumulation. Communicating clearly to clients on expectations and focusing on exceptional service can help mitigate this issue.
Lack of liquidity can compromise best execution
Some performance fee structures only pay out annually or when an investment is realized. This may discourage advisors from rebalancing or making changes that are in the client’s best interest due to lower liquidity. Annual reviews of the appropriateness of the account and flexibility to make tactical changes are important. Advisors should also consider their ability to meet redemption requests if needed.
Difficulty setting an appropriate benchmark
Not all performance fee structures are created equal. Advisors need an appropriate benchmark to measure against, typically an index that matches the account’s goals, risk profile and asset allocation. Custom benchmarks based on a blend of indices may be suitable if the portfolio is unique. Benchmarks should be agreed upon upfront with the client and evaluated regularly.
Performance based fees need to be structured carefully to align incentives without excessive risks. Advisors should communicate clearly, set reasonable performance hurdles and maintain a focus on exceptional service. With appropriate safeguards, performance fees can benefit both advisors and investors.